medium and long-term effects on domestic output of the two policies are, however, basically equivalent.
The fact that the domestic exchange rate depreciates instead of appreciating implies that the main spillover channels through which the domestic tax reduction affects the foreign country—the expenditure switching effect, the terms of trade dynamics, and the accumulation of external surplus/deficit—are now reversed compared to those presented in section IV. This result in a dynamics of foreign output and consumption following domestic consumption tax cuts which is almost a mirror image of the one stemming from domestic income tax cuts (compare Figure 1(a,b) with figure 2(a,b)). In particular, foreign output falls and foreign consumption increases in the short run when the domestic country chooses to stimulate the economy through a consumption-tax based fiscal package. The temporary reduction in foreign output implies that overall foreign revenue collection falls, because the drop in foreign income tax collection is not compensated by higher foreign consumption tax collection (Figure 2(f,h)). Since a domestic income-tax based fiscal package has a positive impact on short-term foreign revenues (Figure 1(f,h)), the negative short-run budgetary spillover derived here is another important difference between the two fiscal packages.
Alternative Options to Achieve a Given Reduction in Transfers
In Figure 2 and Tables 4 and 5 we have presented the results related to a 1 percentage point reduction in the consumption tax rate in order to compare such a fiscal stimulus package with the one (discussed in section IV) based on a 1 percentage point reduction in the income tax rate. A different exercise which can also give an interesting perspective on the comparison of income-tax based versus consumption-tax based fiscal stimulus packages is one in which the
government reduces τ C by the amount needed to stabilize steady-state public transfers at the same level implied by the income-based fiscal stimulus package studied in section IV. This comparison can give some insights on the implications of following different fiscal strategies for governments who have decided to reduce public spending by a given amount.
Since in our model the government budget is balanced in every period and, in the absence of seignorage, total tax collection is always equal to transfers, this exercise boils down to analysing the reduction in consumption tax rate which implies the same steady-state level of total revenue collection derived in section IV. The income tax rate reduction analysed in Section IV reduces total tax collection—and therefore transfers—by 2.9 percent in the new steady-state. The same reduction in transfers can be achieved with a 0.85 percentage points cut in the consumption tax rate. Figure 3 provides a comparison of these two different ways of achieving the same reduction in transfers.